That may seem a strange point to make about a fund that has roughly $210 billion (rmb1,550 billion) to invest. But the sum pales in comparison to China’s roughly $1.7 trillion in foreign exchange reserves. Moreover, about two-thirds of China Investment Corp (CIC)’s assets have either been used to buy the central bank’s existing stakes in China’s financial sector or have been committed to recapitalize additional banks. As a result, much of the fund’s assets have effectively been handed over to the state banks to manage. The $70 billion that the CIC has to invest abroad in 2007 and 2008 is only slightly larger than the monthly increase in China’s reserves in January ($53.9 billion).

Over time, CIC’s assets could grow rapidly. China’s foreign assets are already considerable and are swelling fast: between $500 and $600 billion is pouring into its central bank reserves every year. The state banks are also probably adding to their foreign assets, and so preventing an even larger surge in central bank reserves. The growth in China’s foreign reserves may be roughly equal in size to the US current account deficit. Reallocating the funds now flowing into the central bank could quickly make the CIC the world’s largest sovereign fund.

State Connections

The CIC aspires to be an apolitical investment manager, yet its governance structure has tied it closely to the top level of China’s state: it reports to the state council – not an independent board; moreover, the CIC is not solely an external investment manager as its largest stakes by far are in China’s domestic financial sector. It isn’t obvious why the agency that manages China’s strategic stakes in the large state commercial banks should also manage China’s external equity investments. The relationship between the CIC and other parts of China’s government investing abroad remains murky.

The funds the CIC has injected into the state banking system can be lent out to state firms, and the fund itself has made a small equity investment in the offshore IPO (initial public offering) of a Chinese state firm (China Railway). The CIC’s initial investments have raised as many questions as answers. The fund’s heavy exposure to China’s own financial sector might also have led it to minimize its external investments in the financial sector. The CIC’s lack of experience might have called for initially investing in a highly diversified portfolio, or even starting with index funds.

But the CIC’s existing stakes – at least its disclosed stakes – suggest that it has followed the opposite strategy: the CIC’s big bet on China’s own banks has been combined with bets on Blackstone, Morgan Stanley and now a JC Flowers financial sector fund.

Right now the CIC looks more like the state agency for managing China’s investment in the financial sector – whether in China or abroad – than a diversified global fund manager. The CIC’s reasons for putting most of its eggs in the same financial sector basket have not been clearly explained.

Big challenges

The poor financial performance of the CIC’s existing high-profile investments highlights a broader issue: even if the CIC’s future investments generate higher returns than it has achieved to date, the CIC’s foreign currency returns are unlikely to be sufficient to pay the bonds that China’s ministry of finance has issued to “fund” the CIC. The finance ministry bonds pay 4.5% in RMB – and the RMB is currently expected to appreciate by more than 10% over the next year against both the dollar and the euro. Most investment corporations don’t anticipate generating domestic currency losses, but it is hard to see how the CIC can generate the foreign currency returns that would be needed to offset the renminbi’s likely appreciation. It is impossible to generate returns of 15% in the United States and Europe without taking large risks.

Of course, the CIC’s overarching mission is to support China’s exchange rate regime by investing abroad funds that the finance ministry raises domestically, not to produce a positive return. Expecting the CIC to generate domestic currency return is consequently unfair; the CIC will succeed if it generates a higher return, over time, than China would have made on safe government bonds. But that raises a broader issue: why is the finance ministry raising funds for the CIC to invest abroad rather than raising funds to invest inside China? China remains a poor country with many domestic needs.

Wider implications

The answer to that question doesn’t just matter to China. The sheer scale of the growth in China’s foreign assets means that the way China’s government – Safe and the state banks and others with foreign exchange as much as the CIC – invests will have an enormous impact on global markets. A country adding $600 billion a year to its foreign assets will attract more attention than a country adding $60 billion a year to its foreign assets – or even a country with a $300 billion sovereign wealth fund. The magnitude of China’s reserve growth means that its investment will generate more concerns than investments from smaller, less systemically significant countries. So far the creation of the CIC has made it harder, not easier, to evaluate how much China is intervening in the foreign exchange market to manage its currency. The CIC’s purchases of foreign exchange from the central bank haven’t been disclosed. As a result, the creation of the CIC has led to a net loss of transparency in the global financial system. China could reduce some of the world’s concerns by clarifying the CIC’s mission, disclosing how much all of China’s state – not just the central bank –is intervening in the foreign exchange market and moving expeditiously to embrace global standards of transparency that allow the CIC to build a public track record for responsible management of China’s external investments.